Economic Logic, Too

About Me

I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Thursday, July 31, 2008

I cannot decide whether the new housing aid bill is good or bad. Here is why.

Given the current situation and the number of foreclosures, the forced moves of households and forced sales of homes generate huge transaction costs. They stem from disrupted lives, moving costs, loss of equity, empty houses depreciating, etc. We all know how costly it is to change homes. Imagine do this on short notice and multiply this by a large number. And on the banks' side, their loss of capital (as homes lose value and debt goes bad) hinders them to give credits that could be productive for the economy. And banks have to devote resources to manage the foreclosures. The housing aid bill avoids many of these costs by keeping people in their homes.

However, bailing out homeowners and banks comes at a significant reputation cost for the government. As many have pointed out, this bill rewards the absence of personal responsibility. Those who were responsible will have to ultimately foot the bill. As in many other examples, if the government shows that it is tough in such situations and does not act as a lender of last resort, such situations would never happen. Well, they still may happen if there is limited liability (but less frequently), hence the need for some regulation. But essentially a tough government leads to self-restraint.

In other words, we have a situation that can be improved, but we also face a time consistency problem. The ideal would be that somehow the government would be able to state that it would be helping this time, but never again. This administration being at the end of its term may help, but presidential candidates have shown no sign of a commitment to toughness.

Even if the government strictly refused to bail out anyone, I doubt it would have an effect. The borrowers sure aren't perfectly rational economic actors who would consider an expectation of bailout into their decision. They generally didn't even know what they were getting into.

Likewise, aren't the lenders just individual people who get bonuses through making these bad decisions, regardless of whether the business goes under or not? That is, if they were even one of the few who actually knew they were getting into a bad situation... Didn't the buyers of the AAA rated investments not even understand what the were?

I think if there's a solution, it's not denying bailouts. It's gotta be another factor, another player, oversight, or regulation. Or some form of providing information to the actors that would change their decisions.

I agree with independent accountant. If the government said "but never again", it would not be believed. Even if the government said "but never again", politicians and economists don't have the self-discipline to actually stick to it the next time a financial crisis happens. They always want to "solve" the current problem at hand. (If they did have the self-discipline, they would stick to it this time.)

Also, no one bought houses expecting to lose money. Instead, many people in trouble today thought they had a can't miss way to get rich quick. Thus, threatening not to protect the downside next time is unlikely to have any effect on behavior.

Futhermore, there are many people who got priced out of the housing market during the bubble and chose to rent instead. If their taxes are used to bail out homeowners, then not only are the irresponsible rewarded, but the responsible are punished.

Let me also say that Dean Baker has thought out the housing bailout problem much more thoroughly that anyone else. I recommend reading his recommendations here, here, and here.